FINRA has published guidance for its member firms regarding new Rule 2821 (the “Rule”), which becomes effective on May 5, 2008. As reported in the September 14, 2007 edition of the News Summary, the Rule is designed to improve broker dealer sales practices concerning purchases and exchanges of deferred variable annuities. The Rule requires, among other things, that:

• in recommending a deferred annuity transaction, a registered representative (i) make a reasonable effort to obtain and consider various types of customer-specific information (e.g., age, income, financial situation, intended use of the contract, investment experience and objectives, investment time horizon, risk tolerance and tax status), (ii) have a reasonable basis to believe the customer has been informed, in general terms, of various features of the annuity, (iii) have a reasonable basis to believe the customer would benefit from certain features of deferred variable annuities (e.g., tax-deferred growth, annuitization or death or living benefits), (iv) make a customer suitability determination as to the investment in the annuity and initial sub-account allocations, (v) have a reasonable basis to believe that any exchange transaction is suitable for the customer, considering, among other factors, whether the customer would incur a surrender charge, be subject to a new surrender period, lose existing benefits, be subject to increased fees or charges, and/or has had another exchange within the preceding 36 months, and (vi) document and sign each of the foregoing determinations;
• a registered principal (i) review and approve each sale or exchange transaction (including recommended and unrecommended) prior to submission of the application, no later than seven business days after the customer signs the application, and (ii) document and sign evidence of the principal’s review;
• members develop and maintain supervisory procedures that are reasonably designed to achieve compliance with the Rule, including surveillance procedures and corrective policies and procedures to address inappropriate exchanges; and
• members develop and implement training programs that are tailored to educate registered representatives and registered principals on the features of deferred variable annuities and the requirements of the Rule.

FINRA’s new guidance includes a summary outline of the general division of responsibility under the Rule among registered representatives, registered principals and firms, and also clarifies the scope of certain requirements under the Rule. For example, with respect to the requirement that a registered representative have a reasonable basis to believe a customer would benefit from certain features of deferred variable annuities, the guidance clarifies that a representative need not determine that a customer would benefit from all of these features or that the customer, in hindsight, actually took advantage of one or more of them. Regarding the Rule’s requirement that a registered representative consider whether a customer exchanging one annuity for another has had another exchange within the preceding 36 months, the guidance explains that a representative must determine whether the customer has effected another exchange at the broker-dealer at which he or she is performing the review and must make reasonable efforts to ascertain whether the customer has effected an exchange at any other broker-dealer within the preceding 36 months. The guidance also notes that, although not expressly addressed in the Rule, deferred variable annuities generally are considered to be long-term investments and are therefore typically not suitable for investors who have short-term investment horizons.

With regard to the Rule’s principal review and approval requirements, the guidance notes that the SEC has provided an exemption, and FINRA has provided interpretive relief, regarding several rules that otherwise might have shortened the period within which principals could review the transactions. The guidance also clarifies, in response to comments raised during the rulemaking process, that the principal review must be completed before transmittal of the application to the insurance company. For variable annuities sold by a broker-dealer affiliated with the issuing insurance company, FINRA considers the application “transmitted” to the insurance company only when the broker-dealer’s principal has approved the transactions, provided that the broker-dealer has adequate safeguards in place to prevent the affiliated insurance company from issuing the contract prior to such approval. The guidance also clarifies that notwithstanding that the Rule requires a principal to treat all transactions as if they have been recommended for purposes of his or her review, a principal who determines a given transaction is unsuitable is nonetheless permitted, but not required, to authorize the transaction if he or she determines that (i) the transaction was not recommended, and (ii) the customer, after being fully informed of the reason why the principal found it to be unsuitable, affirms that he or she wants to proceed with the purchase or exchange transaction.

FINRA’s guidance also briefly discusses the requirements of the Rule relating to supervisory procedures and training programs and the use of automated supervisory systems.

FINRA Notice to Members 07-53: Deferred Variable Annuities (November 2007), available at http://www.finra.org/web/groups/rules_regs/documents/notice_to_members/p037421.pdf.

The SEC announced on November 14, 2007 that it has changed the name of the Division of Market Regulation to the “Division of Trading and Markets.” The SEC explained that it believes the new name (which revives the name used for that Division until 1972) will better reflect the Division’s full range of responsibilities.

A press release is available at http://www.sec.gov/news/press/2007/2007-229.htm.

The SEC recently settled two civil enforcement actions relating to alleged violations of the federal securities laws involving short sales. In one action, brought against a hedge fund, its investment adviser and two portfolio managers, the SEC alleged that on multiple occasions the defendants had sold short an issuer’s stock after agreeing to invest in a “PIPE” (Private Investment in Public Equity) offering and then used some or all of the PIPE shares to close out short positions after the effective date of the resale registration statement, a practice prohibited by the registration provisions in Section 5 of the Securities Act of 1933. The SEC’s complaint stated that the defendants’ use of PIPE shares to cover pre-effective date short positions violated Section 5 because shares used to cover a short sale are deemed to have been sold on the date the short sale was made. In the settlement, the defendants agreed to pay a total of $1,195,060 in disgorgement, prejudgment interest and civil penalties.

In the second action, brought against two offshore companies and their owner and principal trader, the SEC alleged that the defendants violated Rule 105 of Regulation M (as in effect at the time of the conduct alleged) under the Securities Exchange Act of 1934 by using shares purchased in public offerings to cover short sales made during the restricted period prior to the public offerings. The SEC stated that the shares were often sold short at prices higher than the price later paid for the shares in the offering. The defendants agreed to pay a total of $1,795,000 in disgorgement, prejudgment interest and civil penalties in their settlement.

SEC Litigation Release No. 20356 (Nov. 5, 2007), available at http://www.sec.gov/litigation/litreleases/2007/lr20356.htm; SEC Litigation Release No. 20361 (Nov. 8, 2007), available at http://www.sec.gov/litigation/litreleases/2007/lr20361.htm.

The SEC denied a request by a principal of a former unregistered investment adviser (the “Principal”) to modify a 1998 SEC order barring him from association with any broker, dealer, investment company, investment adviser or municipal securities dealer. The Principal’s industry bar had followed a criminal conviction for insider trading, conspiracy and mail fraud in connection with a tender offer. The Principal sought to have the 1998 order modified to enable him to associate with an investment adviser that would manage an investment partnership, which he represented would be offered to a limited number of sophisticated investors to whom he would disclose his prior criminal conviction and disciplinary history. The Principal further represented that the investment advisory firm would register as an investment adviser with the SEC, allow regular inspections by SEC staff and retain an independent consultant to monitor all trading and investment activity.

In denying the Principal’s request, the SEC reiterated its position that administrative bars should “remain in place in the usual case and be removed only in compelling circumstances,” in order to ensure protection of investors and the public interest. Among the factors the SEC considered were (i) the serious nature of the violations of the antifraud provisions of the securities laws underlying the Principal’s bar from the industry, (ii) the fact that the Principal had not sought permission to associate with any SEC-regulated entity in a more limited capacity since the imposition of the bar and thus lacked a history of compliance, and (iii) the fact that the Principal now sought to reenter the securities industry as the head (as opposed to a mere employee) of a securities industry firm. The SEC also noted that the retention of an independent consultant to supervise the owner of a firm would create a “difficult supervisory situation.”

Securities Exchange Act Release No. 56744 (November 5, 2007), available at http://www.sec.gov/litigation/opinions/2007/34-56744.pdf.

Linda Chatman Thomsen, Director of the SEC Division of Enforcement, spoke before the ALI-ABA Life Insurance Company Products Conference on November 8, 2007. She discussed the SEC’s ongoing initiative to protect senior citizens from abusive sales practices in the variable insurance industry, including investor education efforts and examination and enforcement activities, such as the “free lunch” examination sweep conducted recently by the SEC’s examination staff, state securities regulators and the Financial Industry Regulatory Authority (FINRA). The “free lunch” sweep looked at the sale, disclosure and supervisory practices employed by firms hosting “free lunch” sales seminars targeted at senior citizens. Ms. Thomsen said that the sweep exam had uncovered many instances of weak supervisory practices, exaggerated or misleading advertising claims, possibly unsuitable recommendations and other potentially fraudulent practices.

Ms. Thomsen also described several recent examples of variable annuity-related SEC enforcement actions, involving allegations ranging from unsuitable advice to outright misappropriation of customer assets. She emphasized that while some of these cases may have involved misconduct by isolated individuals, the Division of Enforcement often finds that “the rogue employee” is able to carry out a fraud in part because of poor supervision and failure by firms to respond adequately to red flags. She also commented on various market timing cases involving variable insurance products, as well as cases involving undisclosed revenue sharing arrangements and improper gifts and gratuities.

The full text of Ms. Thomsen’s speech is available at http://www.sec.gov/news/speech/2007/spch110807lct.htm.

In an address to the Investment Company Directors Conference on November 6, 2007, Andrew J. Donohue, Director of the SEC Division of Investment Management, discussed the Division’s Director Outreach Initiative and the role of fund directors in overseeing various aspects of fund operations. Mr. Donohue noted that since the launch of the Director Outreach Initiative earlier this year, he had met with thirteen different mutual fund boards at their regularly scheduled meetings and is scheduled to meet with seven other boards before the end of the year. He said the two biggest topics that fund directors had discussed with him thus far had been Rule 12b-1 fees and soft dollars. Mr. Donohue mentioned that members of the SEC staff are currently reviewing letters received in response to its solicitation of public comments on Rule 12b-1 in June of this year. He noted that a majority of the comments received came from industry participants opposing substantive rule reform.

As to soft dollars, Mr. Donohue cited three developments that he believes may alleviate some of the difficulties inherent in board oversight of soft dollar usage: (1) the SEC’s 2006 guidance, which clarified the SEC’s views on the types of execution and research services that may be lawfully obtained with soft dollars, (2) new technologies that make it easier for advisers to value with increasing specificity the cost of research and brokerage services obtained with soft dollars, and (3) new requirements in foreign jurisdictions, particularly in the United Kingdom, which are helping move U.S. firms toward greater transparency in soft dollar arrangements. Mr. Donohue also stated that the Division is currently working on a recommendation for guidance to assist fund boards in their oversight responsibilities with respect to soft dollars and other trading practices, including not only equity trading practices but also those related to principal transactions in fixed income securities and other asset classes.

Mr. Donohue emphasized the importance of board oversight of the fair valuation of a fund’s portfolio securities, remarking that this is “a key area where fund directors add value for shareholders.” He also briefly discussed the role of chief compliance officers, and said the Division will examine the extent to which certain board functions could appropriately be delegated to a fund’s chief compliance officer or other party.

The full text of Mr. Donohue’s speech is available at http://www.sec.gov/news/speech/2007/spch110607ajd.htm.

On November 15, 2007 the SEC voted unanimously to propose rule changes under the Securities Act of 1933 that are intended to improve disclosure provided to mutual fund investors. The proposed rules would require that all fund investors receive a clear and concise summary of important information needed to make an informed investment decision, and would encourage funds to use the Internet to allow investors to choose the format in which they receive more detailed information in a more user-friendly format than is currently available.

The SEC stated that the proposal would involve rule amendments requiring every mutual fund prospectus to include key information, including investment objectives and strategies, risks and costs, in plain English in a standardized order at the front of the statutory prospectus. This summary would also include brief information regarding a fund’s top ten holdings, investment adviser, portfolio manager(s), purchase and sale procedures, tax consequences, and financial intermediary compensation. A separate summary would be required for each fund included in a prospectus. The SEC also stated that the proposal would permit a firm to satisfy its mutual fund prospectus delivery obligation by (i) delivering a “summary prospectus” to prospective and existing investors, and (ii) providing the summary prospectus, statutory prospectus, shareholder reports and other information on the Internet in a format that enables investors to effectively navigate the more detailed information in those documents. Moreover, the proposed rule changes would require that the Internet version of the summary prospectus and statutory prospectus be presented in a user-friendly format that enables investors, financial intermediaries, analysts and other parties to move back and forth between related information in those two documents. The Internet information would also be required to be in a format that could be retained permanently by users as an electronic file.

The SEC issued a release containing the details of the full proposal on November 21, 2007.

Enhanced Disclosure and New Prospectus Delivery Option for Registered Open-End Management Investment Companies, Securities Act Release No. 8861 (Nov. 21, 2007), available at http://www.sec.gov/rules/proposed/2007/33-8861.pdf.

As discussed in the August 20, 2007 edition of the WilmerHale Investment Management Industry News Summary, the SEC has proposed rule amendments that would amend the definition of “accredited investor” in Regulation D under the Securities Act of 1933 to add an “investments owned” standard and to provide for future inflation adjustments. The rule proposal also provides for a new Rule 507 under Regulation D, which would permit issuers to engage in limited advertising in a covered offering where each purchaser meets the proposed rule’s definition of “large accredited investor.” As proposed, however, Rule 507 would not be available to pooled investment vehicles that rely on the exclusion from the definition of “investment company” in Section 3(c)(1) or 3(c)(7) of the Investment Company Act. The comment period for this proposal recently closed, and a number of industry associations, including the Investment Company Institute (ICI) and the Managed Funds Association (MFA), have submitted their views on the proposal to the SEC.

A comment letter from the ICI expresses strong opposition to the limited advertising provision of proposed Rule 507 “because it represents a dangerous erosion of the long-established line between public and private securities offerings,” but urges the SEC to preserve the proposed rule’s exclusion of private investment companies from the category of issuers that may engage in limited advertising in reliance on the rule in the event that the SEC ultimately adopts the rule. Among other comments, the ICI also presses the SEC to raise the dollar thresholds in the “accredited investor” standard and to make regular inflation adjustments in the future.

In its comment letter, the MFA expresses support for inflation-based adjustments to the “accredited investor” standard, but recommends the SEC undertake a comprehensive reassessment of the prohibition on general solicitations and advertising in Regulation D, rather than carving out an exception for limited advertising by certain issuers as proposed in Rule 507. The MFA recommends against automatic inflation adjustments on the basis that such adjustments could eventually result in higher dollar thresholds for investment in funds exempt under Section 3(c)(1) of the Investment Company Act than those applicable for investment in funds exempt under Section 3(c)(7). Other recommendations of the MFA include expanding the definition of “accredited investor” to include qualified purchasers, knowledgeable employees, trust grantors, trustees and beneficiaries; and grandfathering current investors to permit continued and additional investments, even if such investors are otherwise rendered ineligible by inflation-based adjustments.

The Securities Division of the Office of the Secretary of the Commonwealth of Massachusetts (MA Securities Division) also submitted comments to the SEC, registering its strong opposition to the Rule 507 proposal. The MA Securities Division supports the addition of a “bad actor” disqualification that would apply to all exemptions available under Regulation D, the proposed alternative “investments owned” revision to the accredited investor standard, automatic inflation-based adjustments to the dollar thresholds, and certain other aspects of the rule proposal.

Copies of these and the other comment letters submitted to the SEC on the rule proposal are available at http://www.sec.gov/comments/s7-18-07/s71807.shtml.

House Ways and Means Committee Chairman Charles B. Rangel has introduced significant tax legislation that would tax carried interest as ordinary income and that would, in addition, require current inclusion of income for certain offshore deferrals. The two proposals, each with an expected revenue impact of over $22 billion dollars over the provided 10-year window, are included as revenue raising provisions in the Tax Reduction and Reform Act of 2007 (HR 3970), which focuses on alternative minimum tax (AMT)relief. The carried interest provision applies to “investment services partnerships,” which would include hedge fund advisers and others who provide advice with respect to securities, real estate or commodities. The limitation on offshore deferrals, requiring current income inclusion as the compensation accrues, would apply both to offshore corporations with investment-related income that is not subject to US or “comprehensive” foreign income tax, as well as to partnerships with investment-related income unless “substantially all” the partnership’s income is allocated to persons other than foreign persons or exempt organizations. Unlike the earlier bill on offshore deferrals, introduced recently by Senator Kerry and Representative Emanuel (the Offshore Deferred Compensation Reform Act of 2007), the Rangel bill aims specifically at investment managers. While there is still uncertainty over the eventual prospects of the legislation, the linkage of the two investment management provisions to the popular AMT tax relief provision increases the chances that some variation of the proposals will make their way into law. The Temporary Tax Relief Act of 2007 (HR 3996) also contains provisions relating to income of partners for performing investment management services being treated as ordinary income received for the performance of services and nonqualified deferred compensation from certain tax indifferent parties.

A copy of HR 3970 is available at http://waysandmeans.house.gov/media/pdf/110/HR%203970%20introduced.pdf.

Walter Lukken, Acting Chairman of the CFTC, testified before a House subcommittee on October 24, 2007, recommending that Congress weigh several changes to the Commodity Exchange Act (CEA), the CFTC’s governing statute, as Congress considers the reauthorization of the CEA. Mr. Lukken also delivered a report to the subcommittee detailing changes the CFTC recommends be made to the CEA to prevent manipulation of energy contracts and other futures in exempt commercial markets (ECMs). Mr. Lukken’s testimony addressed certain aspects of the report’s recommendations, along with other legislative changes recommended by the CFTC to enhance its enforcement authority, particularly with respect to foreign currency trading, and the current penalty scheme under CEA antifraud provisions. More specifically, Mr. Lukken testified that the CFTC recommends that:

•  the CEA be amended such that, upon a determination that an ECM futures contract serves a significant price discovery function, the CFTC would have four new authorities: (i) Require large trader position reporting for that contract, (ii) Require an ECM to adopt position limits or accountability levels for that contract, (iii) Require an ECM to exercise self-regulatory responsibility over that contract in preventing manipulation, and (iv) Provide the ECM and the CFTC with emergency authority over that contract;
  
• Congress clarify the CFTC’s jurisdiction over off-exchange foreign currency transactions (forex transactions) by (i) amending the CEA to require participants in the solicitation of retail forex transactions to register with the CFTC, (ii) closing a loophole that allowed firms to notice register as securities broker-dealers and serve as counterparties to off-exchange forex transactions, and (iii) bolstering the CFTC’s anti-fraud authority over retail forex transactions;
  
• Congress clarify that CEA Section 4b, the CFTC’s main antifraud provision, gives the CFTC the authority to bring fraud actions in off-exchange “principal-to-principal” futures transactions (i.e., transactions in “non-intermediated markets”); and
  
• the CEA be amended to increase the civil and criminal penalties available for certain violations of the CEA such as manipulation, false reporting, and conversion (by increasing the maximum fines under Section 9 to $1 million and the maximum prison sentence to 10 years).

A copy of Mr. Lukken’s testimony is available at http://www.cftc.gov/stellent/groups/public/@newsroom/documents/speechandtestimony/opalukken-29.pdf. A CFTC press release is available at http://www.cftc.gov/newsroom/generalpressreleases/2007/pr5403-07.html.

The staff of the SEC Division of Investment Management has stated that it would not recommend enforcement action under Section 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-2 thereunder (Custody Rule) against any investment adviser that promptly forwards to its client or a qualified custodian client funds or securities that the adviser inadvertently receives in the following circumstances:

• where state or other governmental taxing authorities send client tax refunds to the adviser’s address;
• where administrators of funds established to distribute the settlement proceeds of class action lawsuits or other legal actions send settlement proceeds to the adviser; and
• where stock certificates or dividend checks in the client’s name are sent to the adviser’s address, including stock certificates (or evidence of debt) that are issued as a result of a business reorganization or in a class action lawsuit involving bankruptcy where shares are issued in a newly organized entity.

Under the Custody Rule, a registered investment adviser that has custody of client assets violates Section 206(4) unless, among other things, a qualified custodian maintains those assets. The Custody Rule defines “custody,” in pertinent part, as “possession of client funds or securities . . . unless [the adviser receives] them inadvertently and [returns] them to the sender promptly . . . .” (emphasis added)

The staff stated that it expects that an investment adviser that inadvertently receives client funds or securities would adopt and implement written policies and procedures reasonably designed to ensure that the adviser:

• promptly identifies client assets that it inadvertently receives;
• promptly identifies the client to whom such client assets are attributable;
• forwards client assets to the client or qualified custodian promptly, but in no event later than five business days following the adviser’s receipt of such assets;
• promptly returns to the appropriate third party sender any inadvertently received client assets that are not forwarded to the client or qualified custodian, but in no event later than five business days following the adviser’s receipt of such assets; and
• maintains and preserves appropriate records of all client assets inadvertently received, including a written explanation of whether (and when) the client assets were forwarded to the client or qualified custodian or returned to the third party sender.

The staff noted that an adviser that inadvertently receives client funds or securities only in rare or isolated circumstances may not need to adopt and implement such written policies, but would nonetheless be expected to act in a manner consistent with these guidelines.

Investment Adviser Association, SEC No-Action Letter (September 20, 2007), available at http://www.sec.gov/divisions/investment/noaction/2007/iaa092007.pdf.